CAPITULO II: HACER

UNIT 3: ASSET AND LIABILITY MANAGEMENT IN BANKS

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largely the funds which have been committed in lending, marketable securities, and long-term investments.

Therefore, the management of such funds must be synchronized with the management of the liabilities of the banks. This is because the funds that are embedded in loans, credit facilities, and long-term investments come from the depositors. This brings to the fore the critical issues in asset and liability management of banks.

1. Liquidity Management

The main concern in liquidity management as regards the asset and liability management is the funding liquidity risk embedded in operations of the banks. The funding of long-term loans and other securitised assets with short term liabilities possesses a grave challenge to the banks.

Banks are in the business of ensuring that funds involved in the lending facilities are available with which to meet their customers’ requirements. Poor management of these loan facilities and other investments result in liquidity, interest rate and currency mismatches which is the concerned of the bank operators.

In general terms, failure to manage asset and liability of banks effectively can have dire consequences on the liquidity of any bank. In recognition of this grave implication, it is necessary for the banks to put a workable framework in place to manage liquidity risk.

This involves two critical aspects:

Managing liquidity in the recognition that all the operations of any bank; and Managing liquidity as the panacea of resolving the usual crisis that confronts the commercial banks.

There are appropriate guidelines that banks need to consider in effective liquidity management. Such principles are as identifies below.

Diversify sources and term of funding – concentration and contagion were the killers in the recent crisis.

Identify, measure, monitor and control – it is still surprising that many banks do not fully understand the composition of their balance sheet to a sufficient level of detail to allow for management of the risks.

Understand the interaction between liquidity and other risks – e.g. basis risk – the flow on impact of an event in one area can be devastating to others.

Establish both tactical and strategic liquidity management platforms – keep a focus on both the forest and the trees.

Establish detailed contingency plans and stress test under multiple scenarios regularly.

2. Mismatch Management and Performance Measurement

For practical purposes, a bank needs to decide whether it wants to take a relatively cursory approach to asset and liability management risks. The other consideration is

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whether a bank is prepared to take a more definite approach and target higher long - term earnings which translates into profitable operations.

While the choice is that of the banks a bank normally realise that there is the need for right level of skills and resources to be instituted and committed to support the function. In the face of dynamic nature of banking industry, failure to do this can result in a poorly managed operation which can arise from volatility in core earnings, economic instability, and unpredictable business cycle.

The mismatch position of the asset and liabilities normally results in the interest rate and liquidity risk for the banks. There are various techniques that banks can use to examine the mismatch in a bank’s balance sheet and it can be a difficult process if not supported with adequate systems.

Depending on systems and analytical support that a bank uses in the asset and liability management process, the usual analysis is designed to identify:

static and dynamic mismatch;

sensitivity of net interest income; and

market value under multiple scenarios such as high stress.

The general practice is that majority of the banks normally set net interest income limits as a main measure of performance while the more advanced banks also use market or economic value as a secondary measure.

The use of interest income limits has become the industry benchmark simulation tool because;

it is relatively easy to understand and implement;

it’s a single period measure that does not require many assumptions, and

it is easy for investors to understand because it is linked to reported financial results.

Nevertheless, the approach is limited as it does not provide a full view of the risks of operations of a bank or reflect fully the economic impact of interest rate movements.

Market value or economic value simulations on the other hand, offer a more complete assessment of the risk confronting banks in their operations.

3. Funds Transfer Pricing

The funds transfer pricing system is a fundamental asset and liability management tool in the banking system. The system creates the ability of the bank to immunize its operations from risk.

Therefore, it provides the basis for operational transparency and profitability. The process of funds transfer pricing is normally designed to identify interest margins and remove interest rate and funding or liquidity risk.

The system of funds transfer pricing, from operational perspective, effectively locks in the margin on loans and deposits by assigning a transfer rate that reflects the repricing and cash flow profile of each balance sheet item. This is because it is applied to both assets and liabilities.

The system in the asset and liability management is used to isolate the bank’s business performance into discrete portfolios that can be assigned individualized metrics.

Therefore, it facilitates the centralization and management of interest rate mismatches.

In addition, it also effectively allocates responsibilities between the bank’s business units and the treasury department.

In a sophisticated banking system, the funds transfer pricing mechanism can also be used as a tool to assist with management of the balance sheet structure with its rates adjusted to either encourage or discourage product and customer flows. The inherent advantage is that it can lead to greater understanding of a bank’s competitive advantage and assisting with asset allocation.

The funds transfer pricing rates are normally structured to include both interest rate and funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums.

Such premiums can be used to capture all elements associated with the banks funding cost in terms of the cost of items such as:

holding liquidity reserves, optionality costs;

term funding programme costs; and items such as operational risk.

SELF ASSESSMENT EXERCISE 1

Mention and explain the critical issues involved in asset and liability management in banks.

3.2 FOCUS OF ASSET AND LIABILITY MANAGEMENT